Economic Crisis

The “perfect” storm (or how we messed up so badly).

Many economists believe that the Financial Crisis of 2008 can be directly attributed to placing too much confidence in the ability of the market and not paying enough attention to the possibility of a market bubble breaking.

Real World Examples

Varying interest rates

The markets for homes, automobiles and credit cards help to explain why the interest rates in those markets differ. There are three factors that determine the interest rates that consumers pay: the opportunity cost of borrowing someone else’s money, the risk of default, and the time horizon it takes to repay the loan.

For home loans, the time horizon is typically between 15-30 years. Therefore the inflation premium is large. Lenders are concerned about inflation eroding the value of the future payments they receive on the loan. Offsetting this concern is the risk of default, which is relatively low.

Mortgage Backed Securities

Unfortunately, modeling mistakes are often made and those errors can lead to spectacular policy failures. There is no better example than the Financial Crisis and Great Recession that began in 2008.

In the years leading up to the crisis, banks sold and repackaged mortgage-backed securities under the faulty assumption that real estate prices would always rise. Unfortunately, that premise turned out to be false. From 2006-2008 real estate prices fell. Because of one faulty assumption, the entire financial market teetered on the edge of collapse. This is the danger of poor modeling.